Working on Exit Skills
By Adam Grimes,
Author of The Art and Science of Technical Analysis: Market
Structure, Price Action & Trading Strategies

One of the challenges developing traders face is learning to
manage positions effectively. Think about it for a minute -- how
many books do you know that show patterns and setups for trade
entry? Now, how many do you know that focus on position
management? We probably put too much emphasis on entry techniques,
when much of our edge as traders comes from the decisions we make
in managing positions.

I'm going to suggest an exercise that everyone can do to work on
position management, but let me first share a few thoughts.
Position management means several things: limiting the risk on
your initial entry, taking partial profits (and losses, if you do
that, though I present a very compelling case for not booking
partial losses [edit: a type said "profits" in the first version
of this blog entry] in my book, The
Art & Science of Technical Analysis), looking for spots
to add, and getting out entirely when the edge is gone out of the
trade. Especially for newer traders, this is extremely difficult
because of the emotional issues involved. One solution is to spend
some time focusing only on the exits.

Many professional traders work in teams. In fact, when I was at
the NYMEX, Mark
Fisher went so far as to say that nearly every long-term
successful trader he knew, on or off the floor, worked with a
partner or a team. (Ari Kiev devotes quite a bit of space in Trading
to Win to the importance of teamwork.) I worked closely with
another trader for a few years, and we developed a technique that
worked very well for us: whichever one of us generated the entry
idea and got into the trade, the other one was responsible for
getting out of it. Many times, a trader is very attached to an
idea by the time we actually execute the trade because a lot of
analysis and thought has already gone into it. You have visualized
several scenarios and possible ways the trade might play out, and
it is very easy to justify overstaying your welcome, or getting
stubborn in a trade. If you are only responsible for the exit, you
have no emotional attachment to the trade, and can see much more
clearly. It's a lot easier to read the market and to make
decisions.

Linda Raschke and Andrew Lo created a similar experience for a
number of traders in Linda's chatroom in the early 2000′s. Several
times during the trading day, Linda would call out a trade. If you
were participating in this study, you were obligated to take the
trade, but you could manage it however you saw fit. You could even
get out immediately (usually for a tick or two loss), but you had
to take the trade. Many traders participating in the study were
surprised to find that they were remarkably profitable on the set
of trades even though many of the entries were truly random. The
message is simple -- exit techniques and position management
skills have as much or more to do with profitability than entries.

So, how can you work on developing these skills? I would suggest
something like this. Now, because you're dealing with
psychological issues, papertrading is probably not very effective.
I'd recommend doing this exercise with real money and actual
positions. I'm going to make a separate set of suggestions for
daytraders and intermediate term traders, but you can adapt the
concept to your own situation.

Pick one specific instrument (stock, futures contract or
currency pair) that you are already familiar with and know
reasonably well. Plan to trade it on smaller size than you
usually would. If you trade an equal-risk position sizing plan
(more on this later), perhaps do this exercise on 10% of your
usual 1X risk. If you are the kind of trader who usually
trades a fixed size, perhaps trade 10% - 20% of that size on
each trade. You do not want to nervous doing this, but you do
want to experience the emotions involves with having real risk
in the market.

It probably makes sense to be aware of reports that could
have a major impact on the instrument you're trading and avoid
them. Know your market.

There are two parts to generating the random entries: a
trigger for whether or not you take a trade at all, and a
decision whether to go long or short. If you are a daytrader,
perhaps check for a possibly entry every hour. If you are a
position trader, check every day.

You can decide how often you want to trade, on average, and
then rig a system that will generate that trade frequency. For
instance, let's say you're a daytrader who wants to check
every hour the stock market is open, and you want to take, on
average, two trades a day. In this case, you need something
that gives you an entry 1/3 of the time, so perhaps roll a
six-sided die and take an entry if it's a 1 or a 2. If you
have basic programming or Excel skills, it's pretty easy to do
something with a random number generator instead of rolling
physical die.

For the long/short decision, either bake that into your
first filter (for instance, the guy rolling the six-sided die
could go long on a 1 and short on a 2), or flip a coin after
you have the yes/no on the entry.

The only other rule is you must take the trade indicated
immediately and without question. Don't think, and don't
hesitate. If you want to get out right away, still do the entry
and immediately execute the exit. Otherwise, manage the trade
appropriately.

This is a worthwhile exercise, and it might be a good idea to
budget a certain amount of risk to it over a period of a few weeks
to months. Remember, the whole point of this exercise is to remove
any emotion associated with the entry or trade idea. How can you
be attached to a trade you generated through a flip of a coin or a
roll of a die? Exactly, you cannot, so now you can focus all of
your attention on trade management and learning to respond to the
message of the market as patterns unfold.

Author Bio
Adam Grimes, author of The Art and Science of Technical
Analysis: Market Structure, Price Action & Trading
Strategies, is the CIO of Waverly Advisors, an asset
management and risk advisory firm headquartered in New York. He
began his career as an independent trader focused on agricultural
and currency futures, and moved on to manage a successful private
investment partnership. Grimes's experience as a trader covers
futures, equities, currencies, and derivatives, in time frames
ranging from intraday to multi-month swings. Though he is
primarily a discretionary swing trader, his methodology rests on a
firm foundation of statistical and quantitative research. Grimes
holds an MBA with an emphasis in finance and market
microstructure, and has worked for a number of private investment
firms, as well as having spent several years at the New York
Mercantile Exchange.